Boston Fed's Rosengren Warns of Financial Run Potential

On April 17, Eric Rosengren, president and CEO of the Federal Reserve Bank of Boston, made an important speech at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies titled "Risk of Financial Runs — Implication for Financial Stability."

The speech should be instructive for conservatives concerned about the potential for further aftershocks from the 2008 episode of the ongoing financial crisis to occur in the United States. If anything, the significance of the speech is enhanced by the fact that Rosengren is not himself a conservative and because it can be read together with the recent American Enterprise Institute panel on the Cyprus crisis as a warning that the potential for further destabilizing runs to occur is elevated.

Rosengren listed the Dodd-Frank Act, the new Basel III capital accord, stress tests, greater attention to liquidity and a resolution process for large, systemically important commercial banks as measures intended to reduce the risk of more problems similar to those of 2008, but he asserted that actions directed at less traditional institutions have not moved at the same pace "despite the fact that less traditional financial institutions were at the epicenter of the crisis." He chose to focus on the risk attendant to broker-dealers and "the need to ensure that large broker-dealers will not need to rely on the government safety net in the future."

Specifically, Rosengren was talking about money market mutual funds (MMMFs), which are not covered by deposit insurance and are not required to hold capital and experienced losses and runs in the period leading to the fall 2008 episode. He expressed the hope that the new chairman of the Securities and Exchange Commission (SEC) will continue the effort of Mary Schapiro to pursue reform of the regulation of MMMFs. He also mentioned another problematic asset category, structured investment vehicles, which enable long-term, risky assets to be financed with short-term commercial paper, as another potential source of runs.

Rosengren recalled that the most prominent events of the 2008 episode were the failure of Lehman Brothers and the rescue of Bear Stearns, both of which were broker-dealers. The key point of the speech was: "Despite the central role that broker-dealers played in exacerbating the crisis, too little has changed to avoid a repeat of the problem, I am sorry to say."

He then called for "a re-examination of the solvency risks of large broker-dealers." He warned further that placing broker-dealer units within the framework of a bank holding company "should not obviate the need for the broker-dealer subsidiary to hold more capital," and he emphasized that the extraordinary actions the authorities took to backstop the industry in 2008 were due to the fact that the broker-dealers had not held enough capital to support their activities.

Rosengren presented a series of slides, beginning with an illustration of the structural changes the largest broker-dealer firms underwent in the 2008 episode because they lacked sufficient capital. This restructuring was supported by an array of special programs, including discount window lending, the Primary Dealer Credit Facility and the Term Securities Lending Facility. He concluded flatly that "given that recent history [of the federal support programs], the assumption that collateralized lenders like broker-dealers are not susceptible to runs has been proven wrong."

However, capital regulation of broker-dealers by the SEC "remains largely unchanged." He attached significant moral hazard to this circumstance and worried that the industry might assume that such assistance will be forthcoming again whenever another crisis occurs.

He went on to suggest that because of susceptibility to runs, broker-dealers should be subjected to higher capital requirements, whether or not they are housed in bank holding companies, than are depository institutions of equivalent size.

I believe Rosengren's speech is illustrative of a larger point made in many of these articles, that the financial crisis predates the 2008 episode by several decades and that continues to fester and pose an ever-greater threat to the nation's economy, with the authorities working around the clock to hide embedded losses and exposures on the order of $30 trillion, twice the gross domestic product of the United States.

Meanwhile, nothing has ever been done to contain this threat, in large part because for the financial firms that have structured themselves in a manner that optimizes their "too big to fail" status, the system is working just fine.

On April 17, Eric Rosengren, president and CEO of the Federal Reserve Bank of Boston, made an important speech at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies titled "Risk of Financial Runs — Implication for Financial Stability."